Dichotomous Asset Pricing Model

Liang Zou

Cross-asset derivative securities are studied and a dichotomous asset pricing model (DAPM) is derived that significantly enriches the Sharpe-Lintner-Black capital asset pricing model. An assets beta is shown to be observable ex ante through the price of its cross-market call or put, and the DAPM separately predicts the assets' expected return - beta relations under the upper-market and lower-market conditions. A sufficient condition for the DAPM to hold is that assets return distributions satisfy Ross' (1978) two-fund separation property, which implies that any well-diversified portfolio is both mean-variance and gain-loss efficient.

Key Words: Mean-variance; Gain-loss; Upper-market beta; Lower-market beta; Crossasset derivative security; Dichotomous asset pricing.
JEL Classification Numbers: G12